The RBI Monetary policy was announced on April 06th under fairly mixed circumstances. A lot has changed in the last few months since the demonetization exercise was first undertaken. To begin with, while demonetization did impact growth, the impact was nowhere close to what the pessimists were expecting. On the other hand, it had the salutary impact of substantially increasing the deposit base of the banking system and thus the liquidity in the system. Secondly, the April Fed meet is likely to be a crucial event from a global standpoint. In the March Fed meet, the FOMC had not only hiked the Fed rate by 25 basis points but also hinted at a minimum of 2 more rate hikes during the year. That will keep the RBI wary, especially considering that FPI flows are just about beginning to come back in the month of March. Lastly, the RBI had in its previous Monetary Policy Review, shifted the monetary stance of the RBI from “Accommodative” to “Neutral”. This virtually opens the doors for the RBI to move the repo rates both ways; depending on the economic and monetary situation.
Ahead of the Monetary Policy, the big problem that the RBI has to contend with is of excess liquidity in the system. How did this surfeit in liquidity come about? Firstly, demonetization meant that all currency had to necessarily be routed through the banking channel only. That led to a sharp increase in bank deposits during the period by over $60 billion. With withdrawals continuing to be tepid, this surplus liquidity is likely to stay. Secondly, FPIs have pumped in nearly $6.5 billion into equities and debt in the month of March. One can argue that this is just a partial reversal of the outflow of $12 billion between October 2016 and January 2017. But that outflow was compensated for by inflows from DFIs. With nearly Rs.400,000 crore sloshing around, as per estimates put out by HSBC, the RBI has a major problem of liquidity management on hand. At the outset, this policy’s primary focus is on liquidity management and not so much on rate signals.
Highlights of the April 06th Monetary Policy…
Why did the RBI choose to maintain status quo on rates?
Inflation has been one area or worry for the RBI. The RBI estimates that the average consumer inflation may stabilize at around the 4.5% mark in the first half of the year and at 5% in the second half of the year. This is higher than the RBI target of 4% long-term consumer inflation. The RBI is also concerned that there may be upside risks to inflation due to two principal reasons. Firstly, non-core inflation is still sticky and oil prices have an important role in pushing inflation. While the impact is currently subdued due to a strong rupee, that impact may wane if the rupee starts weakening; which is possible considering that the government needs to give a major boost to exports. Secondly, with the El Nino effect likely this year, SKYMET has already predicted 5% shortfall in rainfall. This could bring back the spectre of food inflation all over again.
The RBI has also spoken about the headwinds from the global market place. With the Fed likely to raise Fed rates by another 50-75 basis points during the year, there is the risk than any rate cut will reduce the yield spread between the US 10-year benchmark bond and the Indian 10-year benchmark bond. This yield differential is, normally, the guiding principle used by foreign portfolio investors while taking their allocation decisions. Normally, if the yield differential is too low then we could see a risk-off trade, where capital flows out of emerging markets like India and into developed economies like the US. That is again a situation that the RBI will want to avoid.
RBI hints at tighter monetary policy risks globally…
One of the key themes of this policy is that the RBI has clearly hinted at the global central banks gradually moving towards tightening. The US is already seeing record low levels of unemployment and inflation getting back to the 2% mark. Monthly PMI numbers have been very impressive in the US. In March, even Europe reported fairly impressive PMI numbers and China seems to be bottoming out on growth. The RBI’s stance is that the 8 years of cheap money policy may be coming to an end. The US has already started tightening and the UK may follow suit. In fact, UK would have started tightening earlier had it not been for BREXIT. Even in Europe and Japan, the rate cutting cycle seems to have bottomed out. Which is of the reasons the Monetary Policy Committee (MPC), in its previous meeting, had clearly shifted its monetary stance from “Accommodative to Neutral”.
Not much of a game plan on liquidity management…
To be fair, the RBI has been going about its liquidity management measures in a quiet manner. The system currently has liquidity to the tune of Rs.400,000 crore and that has depressed yields on treasury bills (T-Bills) to below the repo rate. The RBI has already increased its average absorption from Rs.2002 billion in January to Rs.4483 billion in March. But there were expectations that the government may introduce the Standing Deposit Facility (SDF) to absorb excess liquidity in the system. An SDF is different from the normal liquidity absorption through LAF in that the SDF does not require issue of securities for absorption of liquidity.
What about a pick-up in industrial growth?
That remains the billion dollar question. But, post demonetization, most banks had cut their MCLR by 90 to 100 basis points. This led to over 100% of rate cuts since January 2015 being transmitted to the end customer. With the banking system already flush with liquidity, there is little that rate cut could have done to improve the growth situation. There is also another perspective to this. While the RBI has not cut repo rates, it has compressed the gap between the Repo rate and reverse repo rate from 50 basis points to 25 basis points; as also its gap with the bank rate. This automatically reduces the benchmark bank rate by 25 basis points. Effectively, there has been a small reduction in lending rates.
What is the road ahead for the RBI monetary stance?
For the complete details of the policy deliberations, we will have to wait for the minutes of the MPC meet, which will be released on April 20th. That will give a clearer picture of individual level deliberations. Also, the RBI will have a better clarity on the global situation and the domestic inflation situation by the next monetary policy scheduled to be announced on June 06th. If the global central banks are increasingly shifting towards tapering liquidity and refraining from cutting rates then the RBI may not have much choice. As Dr. Patel himself said, Indian businesses may have to stop believing that rates will only be headed downwards.